Chapter Two
Financial Reporting:
The Cornerstone of a
Market Economy
Economic Demand for
Financial Information
Financial information is needed to:
• Provide information for investment
decisions
• Assure lenders that borrowers can repay
debt
• Assess performance or plan future growth
by internal managers
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Regulatory Demand for
Financial Information
Financial information is required for:
• Enforcement of tax codes
• Promulgating regulations
• Protection of investors and regulation of
the securities market
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Critical Thinking
• Discussion: Imagine a business world in which
there were no clearly defined accounting
practices, no regulation of securities markets,
and no enforcement of accounting practices.
What consequences might result?
• Investors would have no means by which to
compare financial statements between
companies or understand how each company
computed its income and financial position.
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Setting Accounting Standards
Standard-setting bodies
PublicSector
Entities
PrivateSector
Entities
Issue standards, reports, bulletins, and
positions that constitute generally
acceptable accounting principles
(GAAP)
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Contributors to GAAP
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Public-Sector
Standard Setter: SEC
Securities and Exchange Commission:
• Regulates U.S. securities markets
• Holds authority to set accounting and
reporting standards
• Charged with protecting investors from
fraud or inadequate financial disclosures
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Public-Sector Standard Setter:
Oversight Board
Public Company Accounting Oversight Board:
• Operates under the SEC; established by the
Sarbanes-Oxley Act
• Actively participates in standard setting in
cooperation with accountants and advisory
groups
• Establishes or adopts auditing, quality control,
ethics, independence, and other standards
relating to audits
• Conducts inspections of accounting firms
• Conducts investigations and disciplinary
proceedings; imposes appropriate sanctions
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Private-Sector
Standard Setter: AICPA
American Institute of Certified Public
Accountants (AICPA)
Date
Standard-Setting Committee
Operated by AICPA
Before 1959
Committee on Accounting Procedure
(CAP)
Accounting Principles Board (APB)
1959 - 1973
1973 - present Accounting Standards Executive
Committee (AcSEC)
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Private-Sector
Standard Setter: FASB
Financial Accounting Standards Board (FASB):
• Establishes and improves standards of financial
accounting and reporting
• Issues Statements of Financial Accounting
Standards (SFASs), Statements of Financial
Accounting Concepts (SFACs), and other
bulletins
• Emerging Issues Task Force (EITF) studies and
resolves emergency issues for FASB
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Other Private-Sector
Standard Setters
• Institute of Management Accountants
(IMA)
• Financial Executives International (FEI)
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International
Standard Setter
International Accounting Standards Board (IASB):
• Independent, privately funded organization
based in London
• Cooperates with national accounting standard
setters to achieve convergence in global
standards
• Endorsed International Accounting Standards
(IAS) created from 1997 – 2002
• Issues International Financial Reporting
Standards (IFRS) at present
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Challenges in
Standard Setting
• Process is too slow for the fast-changing
business environment
• Results in complex and detailed
accounting standards
• Current rule-based accounting standards
encourage a check-box mentality and
diminish the overall objective of the
standard
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FASB’s StandardSetting Process
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Which accounting rules have
the highest authority?
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Why is Transparency in
Financial Reporting Important?
• Enables investors, creditors, and the
market to evaluate a firm
• Increases confidence in the fairness of
U.S. markets
• Fundamental to corporate governance
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FASB’s Conceptual Framework
for Financial Reporting
The framework addresses:
1. Objectives of financial
reporting
2. Qualitative characteristics of
accounting information
3. Elements of financial
statements
4. Environmental assumptions,
principles, and constraints
that guide financial reporting
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FASB’s Conceptual Framework
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Objectives of Financial
Reporting
1. Provide
information
that is useful
in making
rational
investment,
credit, and
similar
decisions
2. Provide
information that
will help assess
the amounts,
timing, and
uncertainty of
future cash
flows
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3.
Provide
information that
will help investors
do fundamental
analysis of the
assets, liabilities,
and business
activities for a
given period of
time
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Hierarchy of Accounting
Qualities
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User-Specific Qualities of
Accounting Information
• Understandability—Are users able to
perceive the information’s significance?
• Decision Usefulness—Can users translate
the information for making credit,
investment, and other decisions?
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Primary Qualities of Decision
Usefulness
Relevance:
Reliability:
• Information is
capable of making a
difference in users’
decisions
• Information is relatively
free from error and
bias. It measures what
it claims to measure.
Feedback
Value
Timeliness
Predictive
Value
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Neutrality
Verifiability
Representational
Faithfulness
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Secondary Qualities of
Decision Usefulness
Comparability:
Consistency:
• Information is
measured and
reported in such a
way that users can
identify similarities
and differences
among sets of data
• A company applies
the same accounting
rules across time to
allow for
comparability
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What Constraints Impact
Financial Reporting?
Materiality:
• Information must
have the capacity
to affect users’
decisions
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Cost-Benefit:
• Benefits to users
must exceed costs
when preparing and
communicating
financial information
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Accounting and Ethics
• AICPA Code of Professional Conduct—
defines the minimum level of professional
responsibility and conduct applicable to all
practicing AICPA members
Most critical section of the code:
Auditor Independence
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Auditor Independence
• Maintain independence both in fact and in
appearance
• Do nothing to undermine the perception of
outside users that the auditor has any
interest in the outcome of the audit or
performance of the client
• No financial interest in client
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Auditor-Client Relationship
• An accounting firm cannot provide the following
services for a client at the same time it is
performing an audit for that client:
• Bookkeeping
• Design and
implementation
of financial
information
systems
•
•
•
•
•
Legal
Actuarial
Internal audit
Management
Human
resources
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• Broker/dealer
• Valuation
• Investment
banking
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Ethical Decision Making
• Requires commitment beyond rules of
conduct
• Requires the ability to make distinctions
between competing choices and
understand consequences of each choice
• Requires a framework of principles and a
model form applying these principles to
problems
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Ethical Decision-Making Model
1.
2.
3.
4.
5.
Define the problem and gather facts.
List parties affected by decision.
List values and principles to consider.
List alternative actions.
Choose and prioritize:
a) Which party is most important in this situation?
b) Which value is the highest value in this situation?
c) Which action will cause greatest good or least
harm?
d) Prioritize a, b, and c for most important
consideration.
6. Make the decision based on the above factors.
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Check Your Understanding
Q List three economic needs for financial
information.
A To provide information for investment
decisions, to assure lenders that
borrowers can repay debt, and to assess
performance or to plan future growth by
internal managers.
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Check Your Understanding
Q Name two public-sector entities and three
private-sector entities that play a role in
standard setting.
A The SEC and Congress play a role in
standard setting in the public sector. In the
private sector, the FASB, IMA, FEI,
AICPA, and IASB contribute to standard
setting.
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Check Your Understanding
Q What criticisms have been voiced
regarding the current standard-setting
process?
A The process moves too slowly for today’s
marketplace. Resulting standards are too
complex and detailed.
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Check Your Understanding
Q What issues are addressed by the FASB’s
conceptual framework?
A The objectives of financial reporting; the
qualitative characteristics of accounting
information; the elements of financial
statements; and the environmental
assumptions, principles, and constraints
that guide financial reporting.
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Check Your Understanding
Q Describe the concept of reliability as it
relates to the decision usefulness of
information.
A Information should be relatively free of
error or bias. It should also measure what
it claims to measure.
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